How Much Pension Debt Does Houston Owe?

Elena FarahSenior Fellow for Public Financial SustainabilityThe Hobby Center for Public Policy, University of Houston

Last month Moody’s Investors Service published its updated methodology report on estimating public pension liabilities which represent “material financial commitments that affect a government’s financial risk profile.”[1] Most states and localities, including the city of Houston (COH), are routine issuers of bonded debt for public infrastructure projects, and many also frequently borrow short term to ease seasonal liquidity pressures, for example pay operational bills prior to collecting tax receipts and other revenues. The COH has approximately $3.5 billion in outstanding general obligation bonds payable out of property taxes, which is equal to slightly more than two percent of its property values.

Having difficulties accessing capital markets may deprive governments of vital financing tools, jeopardizing their day-to-day operations, as the city of Philadelphia’s dire financial straits and Puerto Rico’s financial fiasco both demonstrated most recently. Puerto Rico’s general obligation bonds are now rated one notch above junk with a negative outlook by all three rating agencies. While Philadelphia’s general obligation bonds are rated somewhat higher as of this writing, its rating is the lowest for the top five most populous cities as city officials are discussing plans to sell its natural gas utility to fund operations.

It is true that municipal defaults and bankruptcies involving general obligation issuances are extremely rare compared to those in the corporate sector or even to special purpose municipal borrowings for hospitals, utilities, etc. Nevertheless, bond ratings remain an industry standard to help investors assess municipal borrowers’ ability and willingness to repay their debt, and governments tend to take them seriously. Equally important, bond ratings reflect a relative ranking of an issuer’s credit quality with respect to its peers, and being an outlier in terms of the credit rating may signal trouble to investors in the market for municipal debt.

Pension liabilities have increased in size across the public sector over the last decade, aggravated by loss of investable assets in the Great Recession, which have been only partially recaptured to date with $2.85 trillion in defined benefit plan assets in 2011 compared to $3.2 trillion in 2007.[2] In several cases, budgetary pressures from unsustainable pension obligations were major drivers of credit downgrades and outlook changes.

Over the last two years, Moody’s, in tandem with other credit rating agencies like Fitch Ratings, has been reviewing its rating methodology in an effort to bring greater transparency and consistency into the analysis of public pension liabilities. Moody’s recent methodology changes to estimating pension liabilities most relevant to the COH are as follows:

Market-based Discount Rate

The present value of benefits will be computed by discounting future pension payments based on the high-grade, long-term taxable bond index rate current as of the valuation date. Most recent Citibank Pension Liability index used for valuation equaled 5.5 percent. Moody’s offers the following rationale for this decision:

Investment return assumptions in use by public plans today are inconsistent with actual return experience over the past decade (when total returns on the S&P500 index grew at about 4.1 percent annually) and today’s low fixed-income yield environment.[3]

A high-grade bond index is a reasonable proxy for government’s cost of financing portions of its pension liability with additional bonded debt.[4]

High-grade bonds are an available investment that could be used in a low-risk strategy to “match-fund” pension assets and liabilities.[5]

To illustrate the sensitivity of unfunded liabilities to interest rate assumptions, today the COH’s unfunded pension liability estimated at the highest discount rate in the nation of 8.5 percent equals $2.6 billion. Estimated at the rate of 7.5 percent (close to the national average of 7.65 percent weighted by the size of the plan), COH’s unfunded liability increases by nearly 50 percent to $3.8 billion; the unfunded pension liability spikes by 262 percent to $9.4 billion when estimated at 4.5 percent.[6]

At the discount rate of 7.5 percent, the unfunded pension liability for the firefighter fund more than doubles, the police fund sees its liabilities jump by a hefty 50 percent, and the municipal fund’s unfunded pension liability increases 30 percent. At the discount rate of 4.5 percent, the projected increase in COH’s pension liabilities is much more dramatic.

Notably, the COH is not required or expected to report its liabilities at these more conservative discount rates. Nevertheless, this is how rating agencies are going to compute them for rating purposes to compare against peers whose pension liabilities will be calculated using the same methodology.

At the same time, the COH is likely to have to comply with the GASB reporting standards passed last year and slanted for implementation by fiscal 2015. GASB requirements also include discounting the unfunded portion of pension liabilities at a more conservative discount rate than the 8.5 percent currently used by the COH’s three pension systems while also recognizing it on the balance sheet for the first time. This means that COH’s reported pension liabilities are likely to increase within the next two years.

This is how Moody’s explains the difference between the market-based discount rate used to compute the present value of pension liabilities and the long-term discount rate used by actuaries for most public pension plans, including that of COH:

The bond index approach to the discount rate is a significant departure from the discount rate typically used in the public sector. In the public sector actuarial approach, the measurement focus is tied to an objective of developing a long-term funding strategy for the pension plan. The discount rate is set equal to the assumed long-term investment return on plan assets and the resulting actuarial accrued liability is essentially a present value of expected future government contributions to the plan.

In contrast, [Moody’s] approach estimates the present value of the stream of future benefit payments accrued by current employees, using current market interest rates as the guide to the current value of future cash flows. This approach is similar to that used in corporate accounting to derive net pension liability. Because the accrued liabilities of most government pensions include projections of active employees’ future salary increases, while corporate pensions do not, [Moody’s] measure of government net pension liability will be more conservative.[7]

Market Value of Assets

Reported market value of assets (as opposed to the actuarial value reflecting smoothing of investment gains or losses over several years) will be used to calculate the funded ratios of assets to liabilities. This is likely to make reported funded ratios more volatile due to their closer link with market performance.

Shorter Amortization Period for Unfunded Liabilities

Unfunded pension liabilities are not due “thirty years from now”, rather they were due yesterday. They represent a shortage of funds that should have been set aside to pay for already accrued benefits for services rendered in the past. As such, unfunded pension liabilities are conceptually similar to debt, albeit unlike bonded debt these obligations may be changed through policy action.

Reflecting this reality, Moody’s will amortize the adjusted net pension liability computed using the assumptions above on a level dollar basis over the period of 20 years. This reflects potential annual cost of addressing prior service liabilities over a time period similar to that of bonded debt.

In contrast, the COH is amortizing its pension liability over 30 years, which is typical for public plans. Six of Texas pension plans have infinite amortization schedules, including the Teacher Retirement and Employer Retirement plans, which together account for the lion share of 68 percent of all pension assets and liabilities in the state. An infinite amortization schedule of unfunded liability is equivalent to never fully repaying it. Several other Texas plans’ creative amortization schedules extend from 35 to 123 years, while amortization between 20 and 30 years is more common.[8]

Conclusion

As a result of the updated rating methodology, Moody’s estimates that “less than 2 percent of the total population of the general obligation and equivalent ratings will be placed on review for possible downgrade. The affected ratings will be for those local governments whose adjusted pension obligations relative to their resources place them as significant outliers in their current rating categories.”[9]

Application of this uniform methodology is likely to produce a set of comparable metrics for investors, plan sponsors and taxpayers to be able to compare the relative health of sponsored plans across different entities, improving overall transparency of the public finance sector overtime.

This is the time of change for public pension plans nationwide. New GASB reporting standards are due two years from now. Rating agencies are adjusting the way they calculate pension expense for their internal credit analysis. It is also time for COH leaders to acknowledge that they may be facing more pension-related debt than previously believed to consider which policy choices are feasible, acceptable and desirable for implementation.

[1] Van Wagner, Marcia and Timothy Blake. “Adjustments to US State and Local Government Reported Pension Data.” 2013. Cross Sector Rating Methodology. April 17.

[2] “State and Local Pensions: An Overview of Funding Issues and Challenges.” 2013. Center for State and Local Excellence.

[3] Van Wagner, Marcia and Timothy Blake. “Adjustments to US State and Local Government Reported Pension Data.” 2013. Cross Sector Rating Methodology. April 17.

5 Responses

Easy answer…if you remove the post employment health care benefits from the total retirement promises it is just under $3 billion today for all three plans combined. Just over ones year’s revenue from taxes and fees we collect to fund the city. The other $3 billion has been quietly converted to Obamacare.

The HFD pension is 92% funded according to their numbers and is in the best shape of the three plans. HPD is around 85% funded I think with more open records available. The employee fund is in the mid 60% range. None of these number reflect the post employment health care obligations though.

This article has an intentional obtuseness to it to hide the answer the headline asks. That tells you what you need to know about the problem. It’s bad.

Um…..after reading all this I have a headache….. so how much pension debt does Houston owe? Just a simple answer without all the percentages and as to who wants to consider which percentage. I need a doctorate in accounting to understand this article. What is the bottom line? The “conclusion” didn’t give it. At least not in English.

Then according to her logic social security and medicaire are complete failures and should be drastically revised or abolished and the Chronicle will be leading the charge just as it has been regarding pensions